Brealey, Myers. Principles of Corporate Finance. 7th edition

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Brealey−Meyers:

Principles of Corporate

Finance, Seventh Edition

VII. Debt Financing 25. The Many Different

Kinds of Debt

Companies, 2003

make a public issue of debt, you must worry about who is to represent the bond-

holders in any subsequent negotiations and what procedures are needed for pay-

ing interest and principal. Therefore the contractual arrangement has to be that

much more complicated.

The second characteristic of publicly issued bonds is that they are highly stan-

dardized products. They have to be—investors are constantly buying and selling with-

out checking the fine print in the agreement. This is not so necessary in private place-

ments and so the debt contract can be custom-tailored for firms with special problems

or opportunities. The relationship between borrower and lender is much more inti-

mate. Imagine a $20 million debt issue privately placed with an insurance company,

and compare it with an equivalent public issue held by 200 anonymous investors. The

insurance company can justify a more thorough investigation of the company’s

prospects and therefore may be more willing to accept unusual terms or conditions.

All bond agreements seek to protect the lender by imposing a number of condi-

tions on the borrower. These conditions tend to be more severe in the case of pri-

vately placed debt. The borrowers are willing to agree to these conditions because

they know that, if the debt is privately placed, the conditions can be modified later

if it makes sense. However, in the case of a public issue it can be extremely cum-

bersome to get the permission of all the existing bondholders.

These features give private placements a particular niche in the corporate debt

market, namely, loans to small and medium-sized firms. These are the firms that

face the highest issue costs in public issues, that require the most detailed investi-

gation, and that may require specialized, flexible loan arrangements. However,

many large companies also use private placements.

Of course, the advantages of private placements are not free, for the lenders de-

mand a higher rate of interest to compensate them for holding an illiquid asset. It

is difficult to generalize about the differences in interest rates between private

placements and public issues, but a typical differential is on the order of 50 basis

points or .50 percentage points.

Project Finance

We are not going to dwell further on the topic of private placement bonds, because

the greater part of what we have had to say about public issues is also true of pri-

vate placements. However, we do need to discuss a different form of private loan,

one that is tied as closely as possible to the fortunes of a particular project and that

minimizes the exposure of the parent. Such a loan is usually referred to as project

finance and is a specialty of large international banks.

Project finance means debt supported by the project, not by the project’s spon-

soring companies. Debt ratios are nevertheless very high. They can be high because

the debt is supported not just by the project’s assets but also by a variety of con-

tracts and guarantees provided by customers, suppliers, and local governments, as

well as by the project’s owners.

Example Here is how project finance was used to construct a large new oil-fired

power plant in Pakistan. First, a separate firm, the Hub Power Company (Hubco),

was established to own the power station. Hubco then engaged a consortium of

714 PART VII

Debt Financing

Of course debt with the same terms could be offered publicly, but then 200 separate investigations

would be required—a much more expensive proposition.

Brealey−Meyers:

Principles of Corporate

Finance, Seventh Edition

VII. Debt Financing 25. The Many Different

Kinds of Debt

Companies, 2003

companies, headed by the Japanese company, Mitsui & Co., to build the power sta-

tion, while the British company, National Power, became responsible for managing

and running it. Hubco agreed to buy the fuel from the Pakistan State Oil Company

and to sell the power station’s output to another government body, the Water and

Power Development Authority (WAPDA).

Hubco’s lawyers drew up a complex series of contracts to make sure that each of

these parties came up to scratch. For example, the contractors guaranteed to deliver

the plant on time and to ensure that it would operate to specifications. National

Power, the plant manager, agreed to maintain the plant and operate it efficiently. Pak-

istan State Oil Company entered into a long-term contract to supply oil to Hubco and

WAPDA agreed to buy Hubco’s output for the next 30 years.

Since WAPDA would

pay for the electricity with rupees, Hubco was concerned about the possibility of a

fall in the value of the rupee. The State Bank of Pakistan, therefore, arranged to pro-

vide Hubco with foreign exchange at guaranteed exchange rates.

The effect of these contracts was to ensure that each risk was borne by the party

that was best able to measure and control it. For example, the contractors were best

placed to ensure that the plant was completed on time, so it made sense to ask them

to bear the risk of construction delays. Similarly, the plant operator was best placed

to operate the plant efficiently and would be penalized if it failed to do so. The con-

tractors and the plant manager were prepared to take on these risks because the

project involved an established technology and there was relatively little chance of

unpleasant surprises.

While these contracts sought to be as precise as possible about each party’s re-

sponsibilities, they could not cover every eventuality; inevitably the contracts were

incomplete. Therefore, to buttress the formal legal agreements, the contractors and

the plant manager became major shareholders in Hubco. This meant that if they

cut corners in building and running the plant, they would share in the losses.

The equity in Hubco was highly levered. Over 75 percent of the $1.8 billion in-

vestment in the project was financed by debt. Some of this was junior debt pro-

vided by a fund that was set up by the World Bank and western and Japanese gov-

ernment aid agencies. The bulk of the debt was senior debt provided by a group of

major international banks.

The banks were encouraged to invest because they

knew that the World Bank and several governments were in the frontline and

would take a hit if the project were to fail. But they were still concerned that the

government of Pakistan might prevent Hubco from paying out foreign currency or

it might impose a special tax or prevent the company bringing in the specialist staff

it needed. Therefore, to protect Hubco against these political risks, the government

promised to pay compensation if it interfered in such ways with the operation of

the project. Of course, the government could not be prevented from tearing up that

agreement, but, if it did, Hubco was able to call on a $360 million guarantee by the

CHAPTER 25

The Many Different Kinds of Debt 715

WAPDA entered into a take-or-pay agreement with Hubco; if it did not take the electricity, it still had

to pay for it. In the case of pipeline projects the contract with the customer is often in the form of a

throughput agreement, whereby the customer agrees to make a minimum use of the pipeline. Another

arrangement for transferring revenue risk to a customer is the tolling contract, whereby the customer

agrees to deliver to the project company materials that it is to process and to return to the customer. One

purpose of transferring revenue risk to customers is to encourage them to estimate their demand for the

project’s output thoroughly.

Notice that the project was not financed by a public bond issue. The concentrated ownership of bank

debt induces the lenders to evaluate the project carefully and to monitor its subsequent progress. It also

facilitates the renegotiation of the debt if the project company runs into difficulties.

Brealey−Meyers:

Principles of Corporate

Finance, Seventh Edition

VII. Debt Financing 25. The Many Different

Kinds of Debt

Companies, 2003

World Bank and the Export–Import Bank of Japan. This was supposed to keep the

Pakistan government honest once the plant was built and operating. Governments

can be surprisingly relaxed in the face of the wrath of a private corporation but are

usually reluctant to break an agreement that lands the World Bank with a large bill.

The arrangements for the Hubco project were complex, costly, and time-consuming.

Not everything was plain sailing. The project was suspended for over a year by the

Gulf War and it looked at one time as if it would be spiked by a Pakistani court ruling

that the interest on the loans contravened Islamic law. Ten years after the start of dis-

cussions the final agreement on financing the project was signed and within a short

time Hubco was producing a fifth of all Pakistan’s electricity.

However, that was not the end of the Hubco story. After the fall of Benazir

Bhutto’s government in Pakistan, the new government terminated the contract

with Hubco and announced a 30 percent cut in electricity tariffs. This inevitably led

to a dispute with the World Bank, which spelled out that, until the dispute could

be resolved, nothing could move on new loans.

Project Finance—Some Common Features

No two project financings are alike, but they have some common features:

• The project is established as a separate company.

• The contractors and the plant manager become major shareholders in the

project and thus share in the risk of the project’s failure.

• The project company enters into a complex series of contracts that distributes

risk among the contractors, the plant manager, the suppliers, and the

customers.

• The government may guarantee that it will provide the necessary permits,

allow the purchase of foreign exchange, and so on.

• The detailed contractual arrangements and government guarantees allow a

large part of the capital for the project to be provided in the form of bank debt

or other privately placed borrowing.

The Role of Project Finance

Project finance is widely used in developing countries to fund power, telecommu-

nication, and transportation projects, but it is also used in the major industrialized

countries. In the United States project finance is most commonly used to fund

power plants. For example, an electric utility company may get together with an

industrial company to construct a cogeneration plant that provides electricity to

the utility and waste heat to a nearby industrial plant. The utility stands behind the

cogeneration project and guarantees its revenue stream. Banks are happy to lend

as much as 90 percent of the cost of the project because they know that, once the

project is up and running, the cash flow is insulated from most of the risks facing

normal businesses.

There are some interesting regulatory implications, however. When a utility

builds a power plant, it is entitled to a fair return on its investment: Regulators are

716 PART VII

Debt Financing

The confrontation between Hubco and the government of Pakistan is described in C. Hill, “Power

Failure,” Institutional Investor (November 1999), pp. 109–119.

Such extremely high debt ratios must rest on the utility’s creditworthiness. In a sense, the utility has

borrowed money “off balance sheet.”

Brealey−Meyers:

Principles of Corporate

Finance, Seventh Edition

VII. Debt Financing 25. The Many Different

Kinds of Debt

Companies, 2003

supposed to set customer charges that will allow the utility to earn its cost of cap-

ital. Unfortunately, the cost of capital is not easily measured and is a natural focus

for argument in regulatory hearings. But when a utility buys electric power, the

cost of capital is rolled into the contract price and treated as an operating cost. In

this case the pass-through to customers may be less controversial.

CHAPTER 25

The Many Different Kinds of Debt 717

For a more comprehensive list of innovations, see K. A. Carrow and J. J. McConnell, “A Survey of U.S.

Corporate Financing Innovations: 1970–1997,” Journal of Applied Corporate Finance 12 (Spring 1999),

pp. 55–69.

Liquid Yield Option Puttable, callable, convertible, zero-coupon debt

Notes (LYONs)

Asset-backed securities Many small loans are packaged together and resold as a

bond

Catastrophe (CAT) Payments are reduced in the event of a specified natural

bonds disaster

Reverse floaters Floating-rate bonds that pay a higher rate of interest

(yield-curve notes) when other interest rates fall and a lower rate when other

rates rise

Equity-linked bonds Payments are linked to the performance of a stock-

market index

Pay-in-kind bonds Issuer can choose to make interest payments either in

(PIKs) cash or in more bonds with an equivalent face value

Rate-sensitive bonds Coupon rate changes as company’s credit rating changes

Ratchet bonds Floating-rate bond whose coupon can only be reset

downward

TABLE 25.2

Some examples of

innovation in bond

design.

25.8 INNOVATION IN THE BOND MARKET

Domestic and international bonds, fixed- and floating-rate bonds, coupon bonds

and zeros, callable and puttable bonds, secured and unsecured bonds, senior and

junior bonds, privately placed bonds and project finance—you might think that all

this would give you as much choice as you need. Yet almost every day some new

type of bond seems to be issued.

Table 25.2 lists some of the more interesting bonds that have been invented in

recent years.

We have already encountered some of these exotic bonds. For ex-

ample, you may remember from Chapter 23 the convertible zero-coupon LYONs,

and in this chapter we cited the “Bowie bonds” as an example of asset-backed

bonds. In Chapter 27 we will also discuss catastrophe bonds whose payoffs are

linked to the occurrence of natural disasters.

Here are a couple more examples of unusual bonds. The first is an issue of a

three-year Japanese yen bond that combined the features of two types of exotic

bond—the reverse floater and the equity-linked bond. The issue by the Norwegian

Christiania Bank came in two parts or tranches. Tranche A paid interest equal to the

prime rate but subject to a maximum (or cap) of 12.8 percent. Tranche B paid inter-

est of 12.8 percent less the prime rate. Thus, if the general level of interest rates rose,

the interest payment on tranche B fell but it was not allowed to fall below zero. If

Brealey−Meyers:

Principles of Corporate

Finance, Seventh Edition

VII. Debt Financing 25. The Many Different

Kinds of Debt

Companies, 2003

718 PART VII Debt Financing

you had invested an equal amount in each tranche, the average interest rate on

your two holdings would have been 6.4 percent.

That was not the end of tranche B’s complications, since the principal payment

was not fixed at 100 percent. Instead it declined if the Japanese stock market fell. If

the index fell by about 50 percent, the bondholder did not receive any principal

payment at all. Thus, investing in tranche B was like buying an unusual floating-

rate note and also selling a put option on the Japanese stock market. To compen-

sate for the possible capital loss, the bonds offered a relatively high rate of interest.

For several years the majority of international issues of yen bonds involved sim-

ilar options. Why? One reason is that life insurance companies in Japan cannot dis-

tribute capital gains to policyholders and therefore had a powerful appetite for

high-yielding bonds even if such investments involved the risk of a capital loss.

Christiania Bank paid a high rate of interest on the package, but it obtained a put

option in exchange. If it did not want to hold onto this put option, it could easily

sell it to foreign investors who were worried that the Japanese equity market was

overpriced and wanted protection against a fall in that market.

Our second example is a pay-in-kind bond (or PIK) issued by RJR Nabisco. The

bond carried an attractive coupon of 15 percent, but for the first few years of the

bond’s life, RJR could choose to pay interest either in the form of cash or of bonds

with an equivalent face value. This gave the company a valuable option. If RJR fell

on hard times and bond prices dropped, it could hand over low-priced bonds in-

stead of hard cash. RJR also had the right to call the bonds. That provided another

valuable option: If interest rates fell and bond prices rose, the company could buy

back the bond for the call price.

It is often difficult to foresee which new securities will become popular and

which will never get off the ground. Sometimes new financial instruments succeed

because they widen investor choice. Economists refer to such securities as helping

to “complete the market.” For example, the unusual weather in 1997–1998 result-

ing from El Niño encouraged a number of firms to market financial contracts that

would pay off in unfavorable weather conditions. These firms hoped that weather

derivatives would prove popular with the newly deregulated energy companies,

the agricultural community, and many other businesses that might wish to protect

themselves against the vagaries of the weather.

Governments may unwittingly play a major role in stimulating financial inno-

vation, for new types of security are often designed to circumvent government

regulations. For instance, we have already seen how one unusual bond, the equity-

linked yen bond, was a consequence of Japanese insurance regulation. Unforeseen

changes in the bond market can also result from changes in the tax rules. One of

the most striking examples was the U.S. government’s imposition of a tax on pur-

chases of foreign securities, which brought about the development of the eurobond

market in the 1960s.

SUMMARY

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Now that you have read this chapter, you should have a fair idea of what you are

letting yourself in for when you make a public issue of bonds. You can issue the

bonds in the domestic U.S. market, in a foreign bond market, or in the international

bond market. International bonds (also called eurobonds) are marketed simulta-

neously in a number of foreign countries, usually by the London branches of in-

ternational banks and security dealers.

The detailed bond agreement is set out in the indenture between your company

and a trustee, but the main provisions are summarized in the prospectus to the issue.

Brealey−Meyers:

Principles of Corporate

Finance, Seventh Edition

VII. Debt Financing 25. The Many Different

Kinds of Debt

Companies, 2003

CHAPTER 25 The Many Different Kinds of Debt 719

The indenture states whether the bonds are senior or subordinated and whether

they are secured or unsecured. Most bonds are unsecured debentures or notes. This

means that they are general claims on the corporation. The principal exceptions are

utility mortgage bonds, collateral trust bonds, and equipment trust certificates. In

the event of a default, the trustee to these issues can repossess the company’s as-

sets in order to pay off the debt.

Most long-term bond issues have a sinking fund. This means that the company

must set aside enough money each year to retire a specified number of bonds. A

sinking fund reduces the average life of the bond, and it provides a yearly test of

the company’s ability to service its debt. It therefore protects the bondholders

against the risk of default.

Long-dated bonds may be callable before maturity. The company usually has to

pay a call premium, which is initially equal to the coupon and which declines pro-

gressively to zero. The option to call the bond may be very valuable: If interest rates

decline and bond values rise, you may be able to call a bond that would be worth

substantially more than the call price. Of course, if investors know that you may

call the bond, the call price will act as a ceiling on the market price. Your best strat-

egy, therefore, is to call the bond as soon as the market price hits the call price. You

are unlikely to do better than that.

The bond indenture also imposes certain conditions on the borrower. Here are

some examples of covenants:

1. Issues of senior bonds prohibit the company from issuing further senior debt if

the ratio of senior debt to net tangible assets is too high.

2. Issues of subordinated bonds may also prohibit the company from issuing fur-

ther senior or junior debt if the ratio of all debt to net tangible assets is too high.

3. Unsecured bonds incorporate a negative pledge clause, which prohibits the

company from securing additional debt without giving equal treatment to the

existing unsecured bonds.

4. Many bonds place a limit on the company’s dividend payments.

Private placements are less standardized than public issues, and they impose

more stringent covenants. Otherwise, they are generally close counterparts of pub-

licly issued bonds. Sometimes private debt takes the form of project finance. In this

case the loan is tied to the fortunes of a particular project.

There is an enormous variety of bond issues, and new forms of bonds are

spawned almost daily. By a principle of natural selection, some of these new in-

struments become popular and may even replace existing species. Others are

ephemeral curiosities. Some innovations succeed because they widen investor

choice and allow investors to manage their risks better. Others owe their origin to

tax rules and government regulation.

APPENDIX

Bankruptcy Procedures

What do Pacific Gas and Electric, Global Crossing, Enron, Fruit of the Loom, and

Kmart have in common? Answer: They have all filed for bankruptcy. In this ap-

pendix we will explain what this involves and we will look at some of the pros and

cons of the U.S. bankruptcy laws.

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Brealey−Meyers:

Principles of Corporate

Finance, Seventh Edition

VII. Debt Financing 25. The Many Different

Kinds of Debt

Companies, 2003

720 PART VII Debt Financing

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Occasionally bankruptcy proceedings in the United States are initiated by the

creditors, but usually it is the firm itself that decides to file. It can choose one of two

procedures, which are set out in Chapters 7 and 11 of the 1978 Bankruptcy Reform

Act. The purpose of Chapter 7 is to oversee the firm’s death and dismemberment,

while Chapter 11 seeks to nurse the firm back to health.

Most small firms make use of Chapter 7.

In this case the bankruptcy judge ap-

points a trustee, who then closes the firm down and auctions off the assets. The

proceeds from the auction are used to pay off the creditors. There is a pecking or-

der of unsecured creditors. The U.S. Treasury, court officers, and the trustee have

first peck. Wages come next, followed by taxes and debts to some government

agencies such as the Pension Benefit Guarantee Corporation. Frequently the

trustee will need to prevent some creditors from trying to jump the gun and collect

on their debts, and sometimes the trustee will retrieve property that a creditor has

recently seized. Managers of small firms that are in trouble know that Chapter 7

bankruptcy means the end of the road and, therefore, will try to put off filing as

long as possible. As a result, when the assets are eventually liquidated, the unse-

cured creditors usually receive only a few crumbs.

Instead of agreeing to a liquidation, large public companies generally attempt

to rehabilitate the business. This is in the shareholders’ interests; they have noth-

ing to lose if things deteriorate further and everything to gain if the firm recovers.

The procedures for rehabilitation are set out in Chapter 11 of the 1978 act. Their

purpose is to keep the firm alive and operating and to protect the value of its as-

sets

while a plan of reorganization is worked out. During this period, other pro-

ceedings against the firm are halted, and the company usually continues to be run

by its existing management.

The responsibility for developing the plan falls on

the debtor firm but, if it cannot devise an acceptable plan, the court may invite any-

one to do so—for example, a committee of creditors.

The plan goes into effect if it is accepted by the creditors and confirmed by the

court. Acceptance requires approval by at least one-half of the creditors voting, and

the creditors voting “aye” must represent two-thirds of the value of the creditors’ ag-

gregate claim against the firm. The plan also needs to be approved by two-thirds of

the shareholders. Once the creditors and shareholders have accepted the plan, the

court normally approves it, provided that each class of creditors is in favor and that

the creditors will be no worse off under the plan than they would be if the firm’s as-

sets were liquidated and distributed. Under certain conditions the court may con-

firm a plan even if one or more classes of creditors votes against it,

but the rules for

a “cram-down” are complicated and we will not attempt to cover them here.

The reorganization plan is basically a statement of who gets what; each class of

creditors gives up its claim in exchange for new securities or a mixture of securi-

ties and cash. The problem is to design a new capital structure for the firm that will

Sometimes small firms file under Chapter 11, but attempts to rehabilitate the firm are rarely success-

ful and the assets eventually have to be liquidated.

See M. J. White, “Survey Evidence on Business Bankruptcy,” in J. S. Bhandari and L. A. Weiss (eds.),

Corporate Bankruptcy, Cambridge University Press, Cambridge, 1996.

To keep the firm alive, it may be necessary to continue to use assets that were offered as collateral, but

this denies secured creditors access to their collateral. To resolve this problem, the Bankruptcy Reform

Act makes it possible for firms operating under Chapter 11 to keep such assets as long as the creditors

who have a claim on those assets are compensated for any decline in their value. Thus, the firm might

make cash payments to the secured creditors to cover economic depreciation of the assets.

Occasionally the court will appoint a trustee to manage the firm.

But at least one class of creditors must vote for the plan; otherwise the court cannot approve it.

Brealey−Meyers:

Principles of Corporate

Finance, Seventh Edition

VII. Debt Financing 25. The Many Different

Kinds of Debt

Companies, 2003

CHAPTER 25 The Many Different Kinds of Debt 721

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(1) satisfy the creditors and (2) allow the firm to solve the business problems that

got the firm into trouble in the first place.

Sometimes satisfying these two condi-

tions requires a plan of baroque complexity, involving the creation of a dozen or

more new securities.

The Securities and Exchange Commission (SEC) plays a role in many reorgani-

zations, particularly for large, public companies. Its interest is to ensure that all rel-

evant and material information is disclosed to the creditors before they vote on a

proposed plan of reorganization. The SEC may take part in a hearing before court

approval of a plan, for example.

Chapter 11 proceedings are often successful, and the patient emerges fit and

healthy. But in other cases rehabilitation proves impossible, and the assets are liq-

uidated. Sometimes the firm may emerge from Chapter 11 for a brief period before

it is once again submerged by disaster and back in the bankruptcy court. For ex-

ample, TWA came out of Chapter 11 bankruptcy at the end of 1993, was back again

less than two years later, and then for a third time in 1998, prompting jokes about

“Chapter 22” and “Chapter 33.”

Is Chapter 11 Efficient?

Here is a simple view of the bankruptcy decision: Whenever a payment is due to

creditors, management checks the value of the equity. If the value is positive, the

firm pays the creditors (if necessary, raising the cash by an issue of shares). If the

equity is valueless, the firm defaults on its debt and petitions for bankruptcy. If

the assets of the bankrupt firm can be put to better use elsewhere, the firm is liqui-

dated and the proceeds are used to pay off the creditors; otherwise the creditors

simply become the new owners, and the firm continues to operate.

In practice, matters are rarely so simple. For example, we observe that firms of-

ten petition for bankruptcy even when the equity has a positive value. And firms

often continue to operate even when the assets could be used more efficiently else-

where. The problems in Chapter 11 usually arise because the goal of paying off the

creditors conflicts with the goal of maintaining the business as a going concern. We

described in Chapter 18 how the assets of Eastern Airlines seeped away as the

court attempted to keep the airline flying. When the company filed for bankruptcy,

its assets were more than sufficient to repay in full its liabilities of $3.7 billion. But

the bankruptcy judge was determined to keep Eastern flying. When it finally be-

came clear that the airline was a terminal case, the assets were sold off and the cred-

itors received less than $.9 billion. The creditors would clearly have been better off

if Eastern had been liquidated immediately; the unsuccessful attempt at resuscita-

tion cost the creditors $2.8 billion.

Although Chapter 11 is designed to keep the firm in business, the reorganization plan often involves

the sale or closure of large parts of the business.

One study found that after emerging from Chapter 11, about one in three firms reentered bankruptcy

or privately restructured their debt. See E. S. Hotchkiss, “Postbankruptcy Reform and Management

Turnover,” Journal of Finance 50 (March 1995), pp. 3–21.

If there are several classes of creditors, the junior creditors initially become the owners of the company

and are responsible for paying off the senior debt. They now face exactly the same decision as the orig-

inal owners. If their equity is valueless, they will also default and turn over ownership of the company

to the next class of creditors.

These estimates of creditor losses are taken from L. A. Weiss and K. H. Wruck, “Information Problems,

Conflicts of Interest, and Asset Stripping: Chapter 11’s Failure in the Case of Eastern Airlines,” Journal

of Financial Economics 48 (1998), pp. 55–97.

Brealey−Meyers:

Principles of Corporate

Finance, Seventh Edition

VII. Debt Financing 25. The Many Different

Kinds of Debt

Companies, 2003

722 PART VII Debt Financing

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Here are some reasons that Chapter 11 proceedings do not always achieve an ef-

ficient solution:

1. Although the reorganized firm is legally a new entity, it is entitled to the

tax-loss carryforwards belonging to the old firm. If the firm is liquidated

rather than reorganized, the tax-loss carryforwards disappear. Thus there is

a tax incentive to continue operating the firm even when its assets could be

sold and put to better use elsewhere.

2. If the firm’s assets are sold off, it is easy to determine what is available to pay

the creditors. However, when the company is reorganized, it needs to

conserve cash. Therefore, claimants are generally paid in a mixture of cash and

securities. This makes it less easy to judge whether they receive a fair shake.

For example, each bondholder may be offered $300 in cash and $700 in a new

bond that pays no interest for the first two years and a low rate of interest

thereafter. A bond of this kind in a company that is struggling to survive may

not be worth much, but the bankruptcy court usually looks at the face value of

the new bonds and may therefore regard the bondholders as paid off in full.

3. Senior creditors who know they are likely to get a raw deal in a reorganization

are likely to press for a liquidation. Shareholders and junior creditors prefer a

reorganization. They hope that the court will not interpret the pecking order

too strictly and that they will receive some crumbs when the firm’s remaining

value is sliced up. In the majority of cases their hopes are realized; often they

receive a substantial portion of the equity of the reorganized company even

though the senior creditors receive less than they are owed.

4. Although shareholders and junior creditors are at the bottom of the pecking

order, they have a secret weapon—they can play for time. On average it takes

two to three years before a plan is presented to the court and agreed to by each

class of creditor. When they use delaying tactics, the junior claimants are

betting on a stroke of luck that will rescue their investment. On the other

hand, the senior claimants know that time is working against them, so they

may be prepared to accept a smaller payoff as part of the price for getting a

plan accepted. Also, prolonged bankruptcy cases are costly (the bankruptcy

proceedings of Wickes Corporation involved about $250 million in legal and

administrative costs).

Senior claimants may see their money seeping into

lawyers’ pockets and therefore decide to settle quickly.

5. While a reorganization plan is being drawn up, the company is likely to

need additional working capital. It is therefore allowed to buy goods on

credit and borrow money. The new creditors have priority over the old

creditors, and their debt may even be secured by assets that are already

mortgaged to existing debtholders. This also gives the old creditors an

incentive to settle quickly, before their claims are diluted by the new debt.

6. While the firm is in Chapter 11, secured debt receives interest but unsecured

debt does not. For unsecured debtholders that is another reason for a fast

settlement.

Franks and Torous found that stockholders received some payoff—usually securities—in two-thirds

of Chapter 11 reorganizations. See J. R. Franks and W. N. Torous, “An Empirical Investigation of U.S.

Firms in Reorganization,” Journal of Finance 44 (July 1989), pp. 747–770. A similar study concluded that

in a third of the cases shareholders received more than 25 percent of the equity in the new firm. See L. A.

Weiss, “Bankruptcy Resolution: Direct Costs and Violation of Priority of Claims,” Journal of Financial

Economics 27 (October 1990), pp. 285–314.

We reviewed these costs in Section 18.3.

Brealey−Meyers:

Principles of Corporate

Finance, Seventh Edition

VII. Debt Financing 25. The Many Different

Kinds of Debt

Companies, 2003

CHAPTER 25 The Many Different Kinds of Debt 723

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7. Sometimes profitable companies have filed for Chapter 11 bankruptcy to

protect themselves against burdensome suits.

For example, Continental

Airlines, which was bedeviled by a costly labor contract, filed for Chapter

11 in 1982 and immediately cut pay by up to 50 percent.

In 1995 Dow

Corning was threatened with costly litigation for damage allegedly caused

by its silicone-gel breast implants. Dow filed for bankruptcy under Chapter

11, and the bankruptcy judge agreed to stay the damage suits. Needless to

say, lawyers and legislators worry that these actions were contrary to the

original intent of the bankruptcy acts.

Workouts

If Chapter 11 reorganizations are not efficient, why don’t firms bypass the bank-

ruptcy courts and get together with their creditors to work out a solution?

Many firms that are in distress do first seek a negotiated settlement. For ex-

ample, they can seek to delay repayment of the debt or negotiate an interest rate

holiday. However, shareholders and junior creditors know that senior creditors

are anxious to avoid formal bankruptcy proceedings. So they are likely to be

tough negotiators, and senior creditors generally need to make concessions to

reach agreement.

The larger the firm, and the more complicated its capital

structure, the less likely it is that everyone will agree to any proposal. For exam-

ple, Wickes Corporation tried—and failed—to reach a negotiated settlement with

its 250,000 creditors.

Sometimes the firm does agree to an informal workout with its creditors and

then files under Chapter 11 to obtain the approval of the bankruptcy court.

Such

prepackaged bankruptcies reduce the likelihood of subsequent litigation and allow

the firm to gain the special tax advantages of Chapter 11.

Alternative Bankruptcy Procedures

The United States bankruptcy system is often described as a debtor-oriented system:

Its principal focus is on rescuing firms in distress. But this comes at a cost, for there

are many instances in which the firm’s assets would be better redeployed in other

uses. One critic of Chapter 11, Michael Jensen, has argued that “the U.S. bankruptcy

system is fundamentally flawed. It is expensive, it exacerbates conflicts of interest

among different classes of creditors, and it often takes years to resolve individual

cases.”

Jensen’s proposed solution is to require that any bankrupt company be put

immediately on the auction block and the proceeds distributed to claimants in ac-

cordance with the priority of their claims.

See, for example, A. Cifelli, “Management by Bankruptcy,” Fortune, October 1983, pp. 69–73.

The pay cut enabled Continental to reduce fares aggressively and improve its load factors, but it did

not solve Continental’s problems. Shortly after emerging from bankruptcy, it was back in the bank-

ruptcy court.

Franks and Torous show that creditors make even greater concessions to junior claimholders in in-

formal workouts than in Chapter 11 reorganizations. See J. R. Franks and W. N. Torous, “How Share-

holders and Creditors Fare in Workouts and Chapter 11 Reorganizations,” Journal of Financial Econom-

ics 35 (May 1994), pp. 349–370.

For example, when TWA reentered Chapter 11 in 1995, it had already agreed to a prepack with its creditors.

M. C. Jensen, “Corporate Control and the Politics of Finance,” Journal of Applied Corporate Finance 4

(Summer 1991), pp. 13–33.

An ingenious alternative set of bankruptcy procedures is proposed in P. Aghion, O. Hart, and J. Moore,

“The Economics of Bankruptcy Reform,” Journal of Law, Economics and Organization 8 (1992), pp. 523–546.